If you’ve ever applied for a loan and been denied — despite your good credit score and history of on-time payments — your debt-to-income ratio may be the unseen culprit.
Your debt-to-income ratio is the total of your monthly debts, divided by your gross monthly income. It’s a simple way for lenders to assess your current debt load — and your ability to take on new debt.
This number isn’t the only way lenders decide whether to give you a new loan. But it’s an important one. Borrowers with high debt-to-income ratios are generally considered at increased risk of defaulting, and may be offered higher interest rates and less flexible terms.
Here’s how to determine yours.
See also: Paying Off Student Loans
1. Determine your gross monthly income
Add up the money you make every month, before taxes, business expenses, and other deductions. If you’re on salary, this is pretty simple — just divide your gross yearly salary by 12.
If you get paid on an hourly basis, add up the number of hours you work per week. If your hours are uneven, you may have to estimate an average number of hours you work. Then multiply that by 4.3, for the number of weeks in a month. (NOTE: Do not multiply by 4, because then you're only accounting for 48 weeks per year. Using 4.3 will get to 51.6 weeks per year ... which is still imprecise, but calendars can be slippery things.)
If you get overtime pay or commissions, you can add up the total amount you earned per year and then divide it by 12, and add it to your monthly pay.
If your earnings are uneven — you’re a freelance worker or small business owner who doesn’t get a regular paycheck, for example — there’s more than one way to find your number.
One option is to take the average by adding up all your income over a three-month period and dividing by three. You can also do it over a yearly period and divide by 12.
2. Add up your monthly debt payments
Now that you have an idea of what you earn per month, it’s time to take a look at your debt. Add up all your recurring loan repayments over a month, including:
- Student loan repayments
- Car loans
- Recurring credit card debt
- Medical debt
- Mortgages or rent payments
- Personal loans
- Alimony or child support payments
- Any other debt you have
3. Divide your debts by your income
This will, in most cases, result in you dividing the smaller number by the bigger one.
For instance, let’s say you make $50,000 a year before taxes and other deductions. Divide that by 12, and your gross income is $4,166 per month.
Then, let’s say that you pay $200 per month on your student loan, $1,500 per month in rent, and $100 per month toward your credit card debt. Your total monthly debt payment is $1,800.
Now, you divide $1,800 by $4,166. The answer you get, rounded to the second decimal point, is 0.43. Multiply that by 100 to get the final figure on your debt-to-income ratio: 43%.
Why this number is important
Your debt-to-income ratio is not a factor in determining your credit score. But lenders still care about this number, because a high debt-to-income ratio is a red flag that you may not be able to handle more debt.
If you’re applying to refinance your student loan, the lender may ask for information on your income and existing debt load so they can calculate your debt-to-income ratio. While every lender is different, many like to see a ratio of 36% or less.
This isn’t the only factor that goes into deciding your creditworthiness. Lenders also assess your credit score and record of on-time payments. Especially for student loan refinancing, factors such as your potential for future earnings can also be a factor.
If you’re applying to refinance your student loan or to get any other kind of credit, it’s smart to know your debt-to-income ratio. This will help you anticipate any problems — and identify strategies for reducing your debt going forward.
Want strategies for reducing your student loan payment? Check out our Refi Ready Calculator to see if refinancing can help.